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80,000 ft. View of Rate Setting and the Role Rates Play in Smart Grid Robert J. Procter, Ph.D. Prepared for the Sustainability & Smart Grid Policy Course Executive Leadership Institute, Portland State University April 2011

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DisclaimerThe views expressed are solely my own and do not necessarily represent the views of OPUC Commissioners or staff.

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My Background• I worked at BPA for 20 years and set rates for my last10 years.• Prior to that, I did study with Harry Trebing, and old school regulator, and former director of the Public Utility Institute at Michigan State University.• My academic training is in economics, particularly micro theory, business economics and competitive markets, and natural resource economics.

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My Perspective on Economic Regulation• Rate setting is a sausage making process.• Rate setting for BPA and Customer-Owned Utilities (COUs) is similar - and different - from rate setting for Investor-Owned Utilities (IOUs).• Major difference - no shareholders with COUs - this affects how risk is addressed.• Some assert that the COUs customers are its shareholders - WRONG!• Unless otherwise noted, what follows focuses solely on IOUs.

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Economic Goal of Regulation This graph shows that the goal of regulation is to allow society to capture gains of lower costs(move right along green curve), more production (Qf,not Qm) with one larger utility while assure price is competitive (Pf not Pm)

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Rate Setting Overview (1)• It is part art, part science.• Regulatory compact – the IOU is granted a monopoly franchise and in return must ‘stand ready’ to serve customer’s needs.• Goals of rate regulation – Make sure that IOU spending is ‘prudent’, they produce electricity economically, and that prices (rates) are set fairly.• Economics defines fair rate as a rate that approximates the competitive result.• The PUC sets what rate of return (return on Equity, ROE) the utility may have an opportunity to earn.

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Rate Setting Overview (2)• Actual ROE the IOU does earn can be <=> than the target set by PUC.• Rate setting involves five steps Step 1: Determine if Costs are Prudent Step 2: Determine the Revenue Requirement Step 3: Determine Cost Allocation Step 4: Determine the Rate Design Step 5: Determine the Rates.• There is a great deal of analysis that occurs at each of these steps.

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Step 1: Prudence Decision• The utility’s costs are reviewed to determine if they are appropriate.• This involves determining if they were ‘prudently’ incurred.• This involves determining if some costs are excessive and should be excluded from rates.

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Step 2: Determine Revenue Requirements (RR) (1)1. The costs to be recovered from the utility’s customers are those prudently incurred costs associated with serving only those customers.2. While this might appear obvious, the utility may incur costs unrelated to serving the customers of the regulated utility and it may incur costs in an ‘imprudent’ fashion. These costs are not to be recovered from rate-payers. Rather, these are costs are covered by other parties, including the shareholders.3. The costs that are counted are the accounting costs that the utility actually incurs (retrospective) - or can be expected to incur (prospective).

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Determine RR (2)4. Costs will likely fall into several large buckets - own generation, own transmission, distribution, maybe conservation separately, maybe power marketing related costs separately (buying and selling power from the market to serve customer needs).5. Costs also fall into one of two large groups - a. fixed (e.g., capital cost of a gas turbine), or b. variable (e.g., cost of gas for the turbine).6. Very detailed accounting ledgers list many, many, specific cost categories, but they can be thought of as falling into the groupings noted in bullets 4 & 5.

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Determine RR (3)• Fixed costs (a combustion turbine, a transmission line, a sub-station, etc.) have been previously incurred and are considered historical.• Variable costs (e.g., gas for the combustion turbine) may either be previously incurred (e.g., a contract) or forecasted.

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Step 3: Cost Allocation (1)This is the process of taking the RR and assigning a portion of it to each rate class.1. A rate class represents a distinct group of customers.2. Common rate classes are: residential, commercial, industrial, irrigation, and street lighting.3. Classes may be further broken into small vs. large commercial, etc.4. A rate class will have its own rate schedule. For example, a rate schedule only for residential customers.5. The way rate classes are defined overlaps with Step 4, Rate Design.

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Cost Allocation (2)5. Customer may have to use several different rate schedules if the utility has disaggregated its energy services. For example, if the utility separates (unbundles) energy from distributing that energy and from transmitting that energy. Then, the RR will similarly be disaggregated in the same way.6. How many products are offered is a policy matter (e.g., residential customers usually buy a bundled product - delivered energy at a cents/kWh basis; we may also buy an environmental product).7. Costs are allocated to customer classes ideally reflecting the costs each class imposes on the utility. Reality: small commercial class bears more cost than it imposes. Both industrial & residential bear less than they impose.

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Step 4: Rate Design (1)1. This refers to the structure of rates.2. By structure, I mean the number of customer classes, and how rates for each class are designed.2. A utility may use a different design for each customer class.3. Rate Deign Options a. Energy charge only ($/kWh) b. Energy charge ($/kWh) + Capacity charge ($/kW) c. (a) or (b) + monthly meter fee ($/mo)

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Rate Design (2)d. Flat energy rates, same price every hour of every day of the year.e. Inclining block energy rate, price per kWh increases as you use more at a given point in time, usually a month. f. Time-of-use (TOU), price per kWh varies by time of day, but not by amount used. g. Real-Time Price (RTP), Price varies to reflect system conditions but not the amount you use. h. Critical Peak Price (CPP), Very high price for a short number of hours in a year. i. Peak-Time Rebate (PTR), A payment to a customer that reflects a cost the utility will avoid .

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Non Time - Based Power Rates, Set Ex Ante• Non time-based rates are rates that are constant with time. They may or may not vary with consumption.• Ex ante rates are rates that are set in advance (ex., the rates we pay at our home or apt.)• Flat energy rate means the price does not vary with either time or total amount you use.• Tiered rates are rates that change with the amount you use (rate is fixed for a given block or tier) but they generally do not vary with time, though they may.

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Time Based Power Rates - General Features (1)• Time based rates may either be dynamic or fixed.• TOU rates are fixed rates (some writers call these dynamic rates and that is wrong).• CPP are set ex ante (far ahead), but they are considered dynamic since the utility calls a critical day based on system conditions close to ‘real time.’

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Time Based Power Rates - General Features (2)• RTP is a dynamic rate that is also typically set ex ante BUT a typical RTP is set a day ahead for a given hour the next day. (ex., it’s 10am now, and the rate for 11am-12noon tomorrow will be based on the forward market price today for 11am-12 noon tomorrow).• PTR works like CPP but the utility pays the customer to reduce consumption (note: This is also one form of demand response).

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Time Based Power Rates - General Features (3)• Interruptible Rate – Utility offers rate with contract allowing utility to signal when to cut use (also has a very high penalty rate if use is not reduced)• Time based rates do not vary with use.

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Step Five – Determine the Rates (1)• This is the process of applying the rate design to the costs allocated to a given customer class.• The capacity charge ($/kW), if there is one, the energy charge ($/kWh), and the meter charge ($/mo.) are determined.• Customer load shape will determine how each customer within a given customer class is affected by the level of these various charges.

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Determine the Rates (2)• In theory, the capacity charge recovers fixed costs and the variable charge recovers variable costs.• In reality, the level of capacity (if any) and energy charges reflect economic and political concerns.

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Why is Rate Design Considered an Element of SG? (1)• Cost to provide electricity varies by time of day, day of week, week of month, and historically little linkage between this cost pattern and rates has led to over-building to meet peak use.• Continuing this into the future requires significant capital spending that is not sustainable (this is a large part of the national view of SG).• While national policy notes seven goals of SG, they can be viewed in terms of managing costs.

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Why is Rate Design Considered an Element of SG?(2)• Numerous experiments have been performed using CPP, PTR, RTP, and TOU rates.• Little impact on total energy use as they tend to shift energy use (Note: Reducing energy use is NOT conservation unless it comes from end use efficiencies).• Studies show that: - Customers are price responsive, even low- income customers, - Reduce peak use by >= 15% (much larger reductions are common), - May slightly reduce total energy use.

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SG Power Rate Options (note: Flat, TOU, Tiered rates do not require AMI)• All the rate options discussed earlier may be used with a utility system with SG components (such as AMI).• Dynamic rates requires AMI (smart meter + two-way communications + computing hardware & software).• AMI and equipment to automatically control consumption holds the promise of greater system efficiencies in peak use.